Financial Risk Management: Steps to Prevent Financial Risks in Procurement

Financial risk management allows businesses to help them know if there are issues in their financial performance. However, not all companies know what strategies can help to address the problems that can negatively impact their performance. 

In this article, I will explain what financial risk management means in procurement. I will discuss the importance of managing financial risk in business, helping you grasp its crucial role in your business performance. 

Additionally, I will share strategies for managing financial risks that I’ve developed and utilized throughout my career as a procurement manager. 

The strategies that I will share are also the things that I’ve been teaching procurement teams across the world. The methods I taught allowed over 1,000+ teams to assess and identify issues in the financial performance of their business, especially in procurement. 

After you read this article, you will know how to evaluate all the issues that can impact your financial performance. Thus, enabling you to utilize the strategies I shared here to improve your overall process. 

What is Financial Risk Management?

If you search on the internet about the top three risks that organizations usually face, financial risks come in the top three. 

This is not surprising as funds are necessary for running and growing any business. Additionally, the external environment with economic downturns, inflations, geopolitical issues, and supply chain disruptions heavily impacts the financial stability of the organization.

This is the reason why businesses take financial risks seriously. Now let’s define what managing this risk is all about. Financial risk management involves analyzing and identifying the potential risks that could negatively impact an organization’s financial performance. 

The purpose of managing financial risk is to develop and implement strategies that will help protect the assets and ensure the stable growth of a company. 

For example, a company realizes that a single supplier exposes them to the risk of supply chain disruptions and price increases. With this in mind, the company diversified its supplier base to source and partner with multiple suppliers. 

Importance of Procurement to Financial Risk Management

Procurement plays a crucial role in mitigating the company’s financial risk because financial risks are usually linked to our suppliers. 

A good example of this is the cash flow. Procurement contributes to the cash flow by agreeing on the payment terms with suppliers that impact DPO (Days Payable Outstanding). If the supplier has liquidity issues, it can bring a negative financial impact on your business. 

You also contribute to the cash flow by optimizing Days Inventory on Hand (DIOH) through the implementation of vendor-managed inventory and just-in-time delivery methods. Therefore, the financial stability and health of your organization rely on maintaining financially sound suppliers.

Financial Risk Mitigation Strategies

The following techniques are financial risk management that are relevant to procurement, allowing you to improve your process in managing financial risks:

1. Financial Health Monitoring

The first thing that you should do to ensure you work with financially able and reliable suppliers is to conduct financial risk assessments during the prequalification and supplier onboarding stages. 

You can get data from your suppliers like their financial statements and audit results. You can also leverage externally available data like their credit score ratings and stability resources. 

There are plenty of external sources that exist in the market and all of them provide financial stability ratings for a particular supplier. By combining internal and external data, you will have a better judgment on the financial health of the supplier that you want to partner with. 

Let me share three tips for this strategy. My first tip is to ensure that you work with financially reliable suppliers. However, you should also consistently monitor any changes to your supplier’s financial score. By doing this, you can take necessary actions quickly when needed. 

My second tip is to assess beyond the basic financial risk ratings. Evaluating suppliers from a broader financial view like negative ESG, legal actions, and regulatory penalties, can offer valuable insights to your suppliers. 

My third and final tip is to evaluate the financial impact of the supplier on your company, including their spending and net revenue. A supplier with minimal spending can still significantly affect your company’s overall net revenue, and vice versa. It’s important to establish thresholds and evaluate suppliers based on these criteria.

2. Hedging

Hedging involves utilizing financial instruments to offset the risk of adverse price fluctuations. Procurement can use a hedging contract, which is a contract between two parties, to buy materials at a predetermined cost and date in the future.

Hedging contracts are usually common in the commodities market to manage price risks, but they can also be used for interest rates, currencies, and other financial instruments.

The first step in the hedging process is to know the risk you want to address. These risks can be currency fluctuation, price volatility, or any financial-related issues.

After identifying the risks, the next step is to determine the appropriate hedging strategy. The available strategies include forward contracts, futures contracts, and options contracts. I will give you a short preview of these contracts.

• The forward contract is an agreement between a buyer and a seller to exchange an asset for a specified price at a future date.
• The future contract is similar to the “forwards” contract, with the only difference being that it takes place on an organized exchange.
• The option contract grants you the right, though not the obligation, to buy or sell an asset at a fixed price—and, in certain cases, at a specific time. It offers the benefits of a forward contract while avoiding the downsides, though it comes with a small fee.

Depending on the material, risk exposure, appetite, etc you can define the best option that fits your business at a set period.

For example, imagine that you own a bakery. It’s January, and you’re planning your budget for the year. You’ll need to buy a bunch of wheat during the harvest season in June or July, but you’re unsure what the price will be. 

If the weather is bad, the wheat supply might be low, leading to increased prices. However, if there’s a good harvest, prices might drop.

To manage this, you contact a wheat farmer and agree to buy 1,000 bushels at $8 per bushel. The farmer agrees, and now both of you can plan on that transaction, regardless of what happens to the harvest or market prices. 

If the price rises to $10 due to a poor harvest, you’ll save $2 per bushel. If it falls to $6 due to a good harvest, you’ll lose $2 per bushel. However, knowing you’ll pay exactly $8 per bushel allows you and the farmer to eliminate risk.

3. Diversification

The third one is diversification. In procurement, you can avoid financial risk by having a well-structured supplier base to secure materials or services. 

By doing so, you can support healthy competition and mitigate the risk of relying on a single supplier, as well as potential price and payment term manipulation.

For example, you have three suppliers of sustainable packaging in your area. You may either split the volumes between them or run tenders frequently to get the best actual prices on the materials.

4. Budgeting

This strategy is one that I know you see coming as it is very obvious and basic. Budgeting, as we all know it, is a helpful process to avoid the risk of overspending. 

Having a comprehensive budget in place offers warnings when finances are out of control and helps you adjust your spending to be in line with company expectations. Here are some tips for budgeting in procurement:

• Identify the items and services you require. For instance, how many reams of printing paper do you need? Begin planning your budget from here. What amount are you willing to allocate for the items?
• Research potential vendors and evaluate their pricing, reputation, customer service, and turnaround time. Consider inflation impact for realistic budgeting.
• Get approval from other stakeholders such as Finance, Accounting, and C-suite. Procurement budget credibility and legitimacy are enhanced by securing buy-in from relevant stakeholders.
• My last tip is to stick to your budget. Integrate your budget into the purchase requisition process, and ensure that all purchases stay within the set business parameters.

Conclusion

Financial risk management enables businesses to identify potential issues that may negatively impact their financial performance. Consequently, procurement plays a vital role in helping companies mitigate any finance-related issues since it is usually linked to suppliers.

The strategies I’ve shared in this article will help you avoid and improve your approach to addressing financial risks that may affect your procurement.

Furthermore, these strategies are not only theoretical but have been successfully applied in real-world scenarios, benefiting thousands of procurement teams that I have taught globally. 

By understanding and applying these principles, you can better navigate the complexities of financial risk in procurement, leading to more stable and predictable business outcomes.